ZIMSEC O Level Principles of Accounting: Introduction to Liquidity Ratios

  • Liquidity is a measure of how well a business can meet its short term obligations as and when they fall due
  • It is usually expressed in terms of how well the entity/business in question can convert its assets into cash
  • Short term obligations include amounts owed to creditors, bank overdraft, interest on debentures
  • Short term obligations are also known as current liabilities
  • These are amounts owing that have to be settled by the business within a period of one year or less
  • In accounting and finance liquidity is usually measured by how well current assets can meet current liabilities
  • Current assets comprise cash and other items that can be quickly converted into cash to pay creditors when they come calling
  • Liquidity ratios are therefore used to express the level of risk that a business will be able or not able to pay its creditors when they demand payment
  • At this level you are required to be familiar with the following liquidity ratios:
    1. Current Asset Ratio
    2. Acid Test Ratio/Quick Asset Ratio
    3. Rate of stock turn now called Rate of Inventory Turnover
  • Liquidity is an important measure as it is quite possible for a business to fail even when it is making a profit
  • This is because if a business fails to settle its liabilities it might be forced to liquidate
  • It assets are then sold in order to pay its liabilities
  • Normally the data/information used to calculate liquidity ratios is readily available in the Statement of Financial Position/Balance Sheet

To access more topics go to the Principles of Accounting Notes.